Stock — [mass noun] The capital raised by a company or corporation through the issue and subscription of shares.
A share represents a unit stake of ownership in a company held by an individual or a group. The capital issued through sale of shares by a corporation is also known as equity capital. The shareholders, or owners of the stock, end up owning some small (or large) percentage of the company, based on the number of shares they own. Compared to banking instruments they are significantly riskier since the financial success and growth of company is never certain. At the same time, purchasing shares of Apple or Google early on (when undervalued) yield much higher returns (or losses) than a money market or savings account.
Companies issue stock to help raise money — this is typically what happens during an IPO, or initial public offering. A company places shares on an exchange (Dow Jones, NASDAQ, etc.) that people can purchase or sell through a broker (Schwab, Fidelity, E-trade, etc.) plus the additional commission.
There are a handful of different types of stock, but there are two that are worth understanding.
When the average person talks about investing in the stock market, they are normally buying and selling shares on a public exchange. More specifically, they own common stock, which is a class of stock with a handful of rights.
Common stockholders are entitled to voting rights – typically in a 1:1 ratio (one vote for one share) – for certain corporate matters. For example, if you own 10 shares of X company, you will get 10 votes. However, there are 349 million shares outstanding which unfortunately means your votes are limited in power compared to larger shareholders such as big banks and retail investors. The other perk of being a shareholder is receiving priority on buying stock to retain their level of ownership.
This is all great and dandy, but there are some significant downsides to being a common stockholder. In reality, not every company will have the same outcome as the big tech companies or a safe blue-chip, or a less volatile, profitable company like Disney or Intel. The reason the FDIC doesn’t insure stock is because there’s a very real chance you can lose money on your initial investment, maybe all of it depending on the company! When a company does go bankrupt, the common shareholders will be the last to get paid, typically the money will go to lenders (debt holder), employees, and preferred shareholders first.
Preferred stock offer some different advantages over common stock. In most cases they provide stockholders with a dividend — mimicking advantages of a debt instrument. Common stock for larger corporation also do the same, but in most cases preferred stockholders for most companies receive this benefit with some added bonuses. Typically, they receive a dividend earlier, more frequently, and at a rate that’s higher than that of their common stock peers. Companies that offer common stock dividend tend to be larger, well established companies such as Chevron, Johnson & Johnson, etc. As these companies aren’t in a high-growth stage where the stock price will be volatile (but are profitable), the wealth from owning these stocks comes through these periodic payments based on the timeframes set by the board of directors.
Preferred stock tends to be less volatile as a lot of the benefit comes from higher interest payments. There are situations where common stock can be more lucrative. It’s important to evaluate any investment based on the risk level you are willing to incur.
What about taxes?
Tax implications of stock or equity fund dividends — Dividends of US companies are treated mostly as qualified dividends and are subject to a maximum federal tax rate of 15% and as regular income for state taxes.
Tax implications for stock or equity fund sale — Gains from the sale of shares held for more than a year are subject to taxation at the long term capital gains rate which is between 15-20% for 2018 depending on the income level. Gains from sales of shares less than a year is treated as regular income and taxed as such. Capital gains can be offset by capital losses, recognized on the sale of shares. A maximum of $3000 of capital losses can be used to reduce taxable income each year and the remaining loss is carried over into the next year.
What goes into share price?
The share price of a company reflects the present value of the future cash flows of the company profits and the prospects for maintaining or growing these profits, based on the product portfolio, cost structure, debt levels, competition and the economic environment.
A profitable company usually invests some or all of its profits back into the business and pays out the rest as dividends, or adds it as cash on its balance sheets. The interest rate used to determine the future values of a firm’s cash flows reflects the riskiness of the cash flows and is usually 2-3 percentage points higher than the risk free 10 year Treasury rate.
One of the key ratios used to determine if the share price is expensive is determined by a company’s Price-to-earnings (P/E) ratio. Companies that display strong earnings and growth prospects are rewarded with higher P/E ratios compared to mature companies with slower growth prospects.
A normal stock market P/E is about 14. A P/E of 7 is cheap and a P/E of 40 would be considered excessive (i.e a capitalization weighted P/E across all stocks). You want to buy when the P/E is low, but you need to understand if the P/E is low because future earnings are in doubt and reflected in a low stock price or if the price is low due to unexplained selling of the stock by other investors.